Fitch Downgrades Staples to 'BB+' on Rating Watch Negative

April 08, 2016 11:07 AM Eastern Daylight Time

NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the Long-term Issuer Default Rating (IDR)
for Staples, Inc. (Staples) to 'BB+' from 'BBB-' and the Short-term IDR
to 'B' from 'F3'. The ratings remain on Rating Watch Negative pending
outcome of the Office Depot acquisition process. Should the acquisition
close, Fitch would expect to rate Staples within the mid to high 'BB'
category.

A full list of ratings follows at the end of this release.

KEY RATING DRIVERS

Standalone Business Expected to Be Flat at Best

The downgrade reflects continued secular headwinds and competitive
challenges in the office products category, which have pressured EBITDA
since 2012. On a standalone basis, Fitch views Staples as having limited
ability to reverse declines in sales and EBITDA over the forecast
horizon, especially given the heightened threat from new entrants in the
contract stationer business.

Staples has fought a number of challenges in recent years, including
both secular headwinds and strengthened competition. The ongoing
digitalization of the workplace has negatively impacted sales of core
office supplies, ink/toner and paper, which represent around half of
Staples volume. Sales of technology products (approximately 20% of
sales) have been weak due to a slowing replacement cycle and saturation
of key products such as laptops and tablets. Fitch expects both of these
headwinds to continue over the forecast horizon.

As sales shift online across many retail categories, new competitors
have emerged in the office products category, pressuring in-store sales
across the industry. Since 2012, Staples' North American retail sales
are down approximately 25% (recently exacerbated by the weak Canadian
dollar) and margins of the combined retail/Staples.com business have
contracted from 8.3% to 4.5%. As a result, EBITDA contribution has
declined nearly 50% from $1.2 billion (57% of total) in 2012 to $650
million (45% of total) in 2015.

Amazon has begun a significant push into office products sales to
contract customers, which will limit market share opportunities for
existing players. Sales and EBITDA to contract customers have been
fairly stable for the last few years underpinning the 'BBB-', rating but
Fitch expects Staples' competitive positioning on a standalone basis
could weaken over time.

In addition to the proposed acquisition of Office Depot, Staples has
undertaken a number of initiatives to combat these challenges. First,
the company has significantly reduced its North American store base by
around 300 units to an expected 1,560 by the end of 2016. Second, the
company has refocused selling efforts around categories including
breakroom and janitorial supplies, which are seeing less secular
pressure. Finally, the company has managed its cost structure through
the removal of over $750 million in expenses over the last three years.

While these efforts have mitigated secular pressures, Staples' sales and
EBITDA have declined each year from their respective peaks in 2011 of
$25 billion and $2.3 billion, respectively. In 2015, sales of $21
billion and EBITDA of $1.4 billion were both 6% below 2014 levels, with
EBITDA margin falling to 6.7% from the 2011 peak of 9%. Fitch believes
medium-term EBITDA will remain flat at best, likely within the $1.2-$1.4
billion range, as industry challenges persist.

Given the above EBITDA expectations, adjusted leverage is expected to
trend in the 3.2 - 3.4x range over the forecast horizon, which Fitch
views as representative of a 'BB+' rating for a secularly challenged
retailer.

Combined Business Would be Stronger but Highly Levered

The Rating Watch Negative on Staples reflects the uncertain outcome of
the acquisition process of Office Depot, which would increase pro forma
leverage to near 5.0x upon consummation given $4.25 billion of
incremental debt issued for Office Depot shares. The incremental debt
will include a $2.5 billion term loan and $1.75 billion drawn on the
company's new $3 billion revolver. This is a slight change in mix from
prior expectations of a $2.75 billion term loan and $1.5 billion drawn
on the revolver.

Should the acquisition close, Fitch would expect to rate Staples within
the mid to high 'BB' category, depending on asset dispositions and
updated views on timing of synergies and debt reduction. Staples ability
to maintain the current 'BB+' rating would require Fitch to be
comfortable with the company's ability to reduce leverage below 3.5x
within 36 months following the close of the acquisition.

Pro forma for the Office Depot acquisition, Staples had EBITDA of
approximately $2.2 billion in 2015, unadjusted for any disposals
required to consummate the transaction. Assuming Staples realizes
50%-70% of the planned $1 billion in net synergies within three years of
the transaction close, EBITDA is expected to be in the range of $2.6 -
$2.8 billion vs. $2.2 billion pro forma 2015 EBITDA. Adjusted leverage
could decline from close to 5.0x pro forma toward the mid-to-high 3.0x
range within 36 months from transaction close, assuming FCF is used
towards debt reduction.

The 'BBB-' ratings of the bank facilities reflects their senior secured
position in the capital structure. The ABL revolver is secured by a
first lien on receivables and inventories and a second lien on the term
loan priority collateral. The term loan is secured by property and
equipment, intellectual property, and equity interests in restricted
subsidiaries, and a second lien on the ABL priority collateral. Both
facilities would be expected to receive a full recovery, resulting in an
'RR1' Recovery Rating with the ratings capped at 'BBB-' in accordance
with Fitch's criteria given the expectation that Staples' IDR would be
'BB' or 'BB+'.

--Projected free cash flow after dividends (FCF) of $300 million in 2016
will be used for merger-related debt issuance expenses of $100 - $150
million and merger breakup fees of $250 million. FCF is expected to
remain in the $300 million range annually and could be used to restart
the company's share buyback program.

--Adjusted leverage is expected to remain in the 3.2x-3.4x range.

Combined Staples/Office Depot Entity:

--Sales are expected to be close to pro forma levels of around $35
billion over the forecast horizon, assuming no further divestitures are
required.

--Assuming Staples realizes 50%-70% of the planned $1 billion in net
synergies within three years of the transaction close, EBITDA is
expected to be in the range of $2.6 - $2.8 billion vs. $2.2 billion pro
forma EBITDA in 2015.

--FCF is expected to grow from $700 million in 2017 to $1 billion by
2019, depending on timing of restructuring charges. Fitch expects
Staples to use FCF for debt reduction. As a result, adjusted leverage
could decline from close to 5.0x pro forma toward the mid-to-high 3.0x
range within 36 months from transaction close.

RATING SENSITIVITIES

Fitch would expect to rate Staples' IDR in the mid to high 'BB' category
assuming the merger closes. Staples ability to maintain the current
'BB+' rating would require Fitch to be comfortable with the company's
ability to reduce leverage below 3.5x within 36 months following the
close of the acquisition.

If the merger is terminated, future developments that may, individually
or collectively, lead to a negative rating action include continued
negative sales and margin trends and declines in EBITDA that drive
adjusted leverage above the mid-3x range.

Future developments that may, individually or collectively, lead to a
positive rating action include a stabilization of top-line trends, the
resumption of positive EBITDA momentum, and maintenance of adjusted
debt/EBITDAR at or under 3x.

LIQUIDITY

The company had adequate liquidity at Jan. 30, 2015, comprised of $825
million in cash and full availability on its $1 billion revolving credit
facility.

The ratings remain Rating Watch Negative. Given the Watch is related to
a merger, Fitch would review the company at the earlier of the close of
the merger process or 12 months.

In addition, Fitch has affirmed the following ratings:

--$3 billion secured revolving credit facility at 'BBB-/RR1';

--$2.5 billion secured term loan at 'BBB-/RR1'.

Summary of Financial Statement Adjustments - Financial statement
adjustments that depart materially from those contained in the published
financial statements of the relevant rated entity or obligor are
disclosed below:

--Historical and projected EBITDA is adjusted to add back non-cash stock
based compensation and exclude restructuring charges. In 2015, Fitch
excluded $38 million in accelerated depreciation and expenses related to
its proposed acquisition of Office Depot. Fitch added back $63 million
in non-cash stock based compensation to its EBITDA calculation.

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